Financial markets have not exactly gone to plan so far this year.
To the tut-tutting of big money managers, January brought gains in the value of risky assets — a vote of confidence in the soft-landing narrative. At the same time, government debt markets kept up their warnings of a serious recession ahead with robust demand for long-dated bonds that crammed their yields below short-term debt — the dreaded inverted yield curve that has been the harbinger of so many downturns.
“Something seems amiss to me,” Greg Peters, co-chief investment officer at PGIM Fixed Income, told me at the start of this week. “You can’t have a steeply inverted curve, rate cuts being priced in presumably because recession is looming, and risk assets not really pricing in those outcomes. All those things can’t be true.”
He was right. After Friday’s release of data showing the US economy added more than 500,000 jobs in January, streaks ahead of the 185,000 expected, it feels like the recession bet simply must be wrong.
That is great news for the average human. It is less great news for economists and fund managers, who had almost unanimously pencilled in an economic downturn, judging from the annual exercise by investment house Natixis to scour the thousands of pages of year-ahead outlooks from big banks and asset managers. (Thank you for your service, Natixis.)
Its analysis shows that the supposedly big brains in the market were, in aggregate, neutral on the US stocks and outright negative on Europe. This has worked out very badly so far. By the time February kicked off, stocks in both regions were up by about 6 per cent.
But the apparently rude health of the US jobs market suggests that downbeat view on stocks may turn out to be right, for the wrong reasons. It completely resets the main risk to markets for the rest of this year.
Now, said Mike Bell, global market strategist at JPMorgan Asset Management, “the big risk to markets this year is not a recession but a labour market that remains robust. This would mean the Fed cannot deliver the rate cuts that the market is pricing in.”
To wit, when stocks opened an hour after the employment data, the US’s S&P 500 index dropped a chunky 1 per cent before regaining a little poise.
Alan Ruskin, a strategist at Deutsche Bank, pointed out that the numbers were a little out of whack. “There is a feeling that the labour market just does not fit with multiple other weak growth signals,” he said in a note to clients. “This is true.”
Still, he added, “at a minimum the data adds to the perceptions of a unique cycle, requiring a unique policy response”. It also rips up many investors’ game plans for the year, precisely because it hands the Federal Reserve a golden opportunity to raise interest rates much higher than market participants had previously expected.
Even before the non-farm payrolls data, some investors fretted that the rally in stocks, which has been in play since October, would eat itself, by generating excess exuberance and, by extension, more inflation. But bulls were prepared to stick with it, in part because the interest rate setters in the US did not tell them they were wrong.
This week, the Fed delivered a slimmed-down quarter-point rise in interest rates. Chair Jay Powell told reporters “we’ve got a long way to go” to get inflation under control. But at the same time, he noted the emergence of disinflationary forces, and, importantly, passed up the opportunity to say that frothy markets had got ahead of themselves.
So, now what? This is certainly a vindication for those who believed the rally in risky assets, particularly in the US, had run too far.
Among them is Iain Cunningham, co-head of multi-asset growth at asset manager Ninety One. He is of the view that the full force of the super-aggressive monetary tightening in 2022 had not yet properly leaked into asset valuations. “What the Fed’s done and the ECB — that degree of tightening is definitely going to bite,” he says.
He was looking on at the rise and rise in stocks at the start of this year in disbelief, convinced that recession risks were simply not properly reflected. Again, he may turn out to be right about the market, and wrong about the recession, but the result is the same: the point at which the market is crying out for interest rate cuts and the Fed jumps the other way is the moment that “risk assets really don’t like”, he says.
Investors now have to go back to the drawing board and sort out their thinking about what will really drive markets this year. Like the Fed, they will struggle to make meaningful guesses about the future and instead will need to be flexible from one data release to the next.
“It is pretty clear the market has been caught ‘offside’ when it comes to the favourite trades of the year,” said Deutsche’s Ruskin. “At a minimum this data will demand traders retreat and regroup.” They may also have to embrace being wrong.